Adjustments And Their Effect On Final Account

Adjustments And Their Effect On Final Account

Final Accounts are prepared, normally, for a complete period. It must be kept in mind that expense sand incomes for the relevant accounting period are to be taken, while preparing final accounts.If an expense has been incurred but not paid during the period, a liability for the unpaid amount should be created, before finding out the operating result and financial position of a concern. In order to prepare the final accounts on mercantile system of accounting, all expenses and incomes relating to the period, whether incurred or not, received or not, should be brought into the books.For doing this, a concern is required to pass certain entries at the end of the year to adjust the various items of incomes and expenses. Such entries are called adjusting entries.

 Adjustment item 1st Effect 2nd Effect Closing Stock Credit side of Trading Assets side of a/c Balance Sheet Outstanding Expenses Debit side of Trading and Profit & Loss a/c Liabilities side of by way of addition to Balance Sheet expenses Prepaid Expenses Debit side of Trading and Profit & Loss a/c Assets side of by way of deduction Balance Sheet from Expenses Contd…

 Adjustment item Accrued Income (income earned but not received) 1st Effect 2nd Effect Credit side of profit & loss a/c by way of addition to Assets side of Balance Sheet income Income Received in Advance (income Credit side of Profit & loss Liabilities side of the received but not a/c by way of deduction Balance Sheet earned in the from the income financial year) Depreciation Assets side of Balance Sheet Debit side of Profit & Loss by way of deduction from a/c the value of concerned asset. Bad Debts Assets of Balance Sheet by Debit side of Profit & Loss way of deduction from a/c sundry debtors. Contd…

  Adjustment item 1st Effect 2nd Effect Interest on Capital Liabilities side of the Debit side of Profit & Balance Sheet by way of Loss a/c addition to the capital. Interest on Drawings Liabilities side of Balance Credit side of Profit & Sheet by way of addition Loss a/c to the drawings which are deducted from the capital. Debit side of Profit & Loss a/c or by way of addition to Bad Debts. Provision for Doubtful (Old provision for Debts doubtful debts at the beginning of the year will be deducted) Assets side of Balance Sheet by way of deduction from sundry Debtors (After deduction of further bad debts, if any). Contd…

  Adjustment item Provision for Discount on Debtors Reserve for Discount on Creditors 1st Effect Debit side of Profit & Loss a/c Credit side of Profit & Loss a/c Deferred Revenue Debit side of Profit & Expenditure Loss a/c 2nd Effect Deduction from Debtors (after deduction of further bad debts and provision for doubtful debts) on the assets side of the Balance Sheet. Liabilities side of the Balance Sheet by way of deduction from creditors. Assets side of Balance Sheet by way of deduction from capitalized expenditure. Contd…

  Adjustment item 1st Effect 2nd Effect Loss of Stock by Fire If the stock is fully Credit side insured Account of Trading Assets side of Balance Sheet It will be shown on the credit side of Trading Account with If the stock is partly the value of stock and shown insured on the debit side of Profit & Loss a/c for the part of the stock which is not insured Loss of stock by fire is shown on assets side of Balance Sheet with the amount which is to be realized from the insurance co. i.e., that part of the loss which is insured. If the stock is not Credit side of Trading a/c insured Debit side of Profit & Loss a/c Contd…

  1st Effect 2nd Effect Reserve Fund Debit side of Profit & loss a/c along with net profit in the inner column Liabilities side of the Balance Sheet. If reserve fund is already there, it will be shown by addition to the existing reserve fund on the liabilities side of the Balance Sheet. Goods distributed as Free Samples Debit side of Trading a/c by way of deducted from the purchases Debit side of Profit and Loss a/c as Advertisement expenses. Adjustment item Contd…  Adjustment item 1st Effect 2nd Effect Managers Commission Debit side of Profit & Loss a/c Liabilities side of Balance Sheet Goods on sale or Approval Basis Credit side of Trading a/c by way of deduction from the sales at sale price and added to the closing stock at cost price Assets side as a deduction from sundry debtors sale price) and stock at cost on the Assets side of the Balance Sheet.

 Main Types Of Adjustments

• Accrued Expenses
• Prepaid Expenses
• Accrued Revenue
• Unearned Revenue
• Depreciation of Asset
• Interest on Capital
• Interest on Drawings

Accrued Expenses

There are certain expenses, which have been incurred but not paid. These expenses are called outstanding expenses. For example, salary to the clerk Rs. 10,000 is due for the month of December. Books are closed at the end of December. In order to bring this transaction into accounts, the following adjustment entry will be passed:Salary Account …..Dr Rs.10,000 To Outstanding Salary A/c.Rs. 10,000 The two fold Profit & Loss Account.(ii)Outstanding Salary Account, being personal and having credit balance, will be shown on the liabilities side of the Balance Sheet.

Following adjusting entry will be passed:

Salaries A/c.................................................. Dr. 10,000

             Outstanding A/c....................................... 10,000

Prepaid  Expenses

Those expenses which have been paid, in full, but their utility or benefit has not expired during the accounting period are called prepaid or unexpired expenses. In other words, amount has been paid even for the period subsequent to the balance sheet date. For example, annual premium Rs. 12,000 is paid on 1st July, where accounting year closes on 31st December. Rs. 6000 will reinsurance paid in advance.

The following adjusting entry will be passed:

Prepaid Insurance Premium Account….............Dr.Rs. 6,000
              Insurance Premium ............................................Rs. 6,000

Accrued Income

Income earned but not received during the accounting period is called accrued Income.

Suppose, the interest on investments shown in the trial balance is Rs. 19,500.The adjustment may run like this. Interest @10% is due on investments of Rs. 10,000 for 6 months, though accrued, has not been yet been received.This interest Rs. 500 will be accrued income. In order to bring this into account.

The following adjusting entry will be passed:

Accrued Interest on Investments Account …..Dr Rs........ 500

                      Interest on Investment Account Rs....................500

Unearned Revenue

Sometimes, the amount received in respect of an income during the year pertains, partially, to the next year. Suppose a landlord corrects rent for one quarter, in advance, and closes his account on 30th June each year. Suppose, a tenant has occupied a house on 1st June and pays Rs. 1,800 as rent for 3 months. The landlord must not treat the whole of the rent received as income for the current year. Two months’ rent pertains to the next year and should be credited to the Profit and Loss Account of next year. This will ensure that the income for the current year is not overstated.

The required entry is:

Rent Account….Dr Rs.....................................................1,200

     Rent Received in Advance Account Rs............................1,20

Depreciation Of Asset

The value of fixed assets goes on reducing year by year because of wear, tear and flux of time. This fall in the value should be treated as a loss or expense, to be considered before profit or loss is ascertained. The value to be shown in the Balance Sheet must also be, suitably, reduced.To continue to show it at the old figure will be overstating the assets. Depreciation is usually computed on the basis of the life of the assets. Suppose, a machine costs Rs. 1,00,000 and has a life of 5 years. Then, each year 1/5th of the cost, i.e., Rs. 20,000 should be treated as an expense; only the remaining amount is to be shown in the balance sheet.

 The entry is:

Depreciation Account…Dr Rs................................... 20,000

       Machinery Account........................................................20,000

 Interest on Capital

The proprietor may wish to ascertain his profit, after considering the interest for the amount invested in the firm. Suppose, the capital is Rs. 2,00,000 and the rate of interest is 5%. Then,the interest will be Rs. 10,000. It will be treated like other expenses and debited to the Profit and Loss Account; the amount will also be credited to the Capital Account.

The entry is:

Interest on Capital Account ….........................Dr Rs.10,000

            Capital Account......................................................10,000

Interest on Drawings

The proprietor may also realize that when he draws money for private use, the firm loses interest as funds for business are reduced. Therefore, the proprietor’s capital may be debited with the interest on the money drawn by him. Interest will depend on the amount and the date of withdrawal concerned. In absence of information about the date of drawings, it should be assumed that the drawings were made, evenly, throughout the year; therefore, interest should be charged for six months on the full amount. Suppose, capital is Rs. 2,00,000 and the total drawings are Rs. 10,000. The rate of interest is 6% on the drawings.The average amount of drawings on which interest is to be charged is Rs. 5,000. So, interest@ 6% on drawings Rs. 5,000 will be Rs. 300.

 The entry to be passed is:

Interest on Drawings .............................................Dr  Rs. 300

           Profit & Loss Account Rs............................................. 300
  

Provision for Bad Debts

Prudent accounting principle is to make provision for expected losses and not to take credit for expected profits.
All credit sales would not be realized in the year in which the sales are made. Sales may be made in one year and actual realizations may happen in the succeeding year. A firm, therefore,makes provision at the end of the accounting year, for likely bad debts, which may happen during the course of the next year. The simple reason is all collections do not occur in the same year in which sales are made. Some sales are likely to become bad in the course of the next year.So, the proper course would be to charge such likely bad debts in that accounting year in which sales have been made, since, the profit on such sales has been considered in the year in which the sales have been made.

The following journal entry is passed for creating a provision for bad debts:

Profit & Loss A/c Dr Rs..............................................1,000

             Provision for Bad Debts.....................................1,000